Q: I have executed a 1031 transaction on my cabin and purchased another lake home. How can I turn the lake home into my primary residence and eliminate the capital gains tax that was generated through the 1031 transaction?

A: A 1031 Exchange or Starker Trust exchange or “like-kind” exchange are all terms used to describe the sale of one investment property for another.

When you sell investment property, you need to pay tax on any gains you have realized on the sale. To avoid paying taxes, you are permitted to sell one property in exchange for another. While the rules are quite technical, you are allowed to sell one investment property for another, similar investment property. So if you sell real estate you need to replace the property with another real estate property.

The provision of the Internal Revenue Service Code that permits this transfer is Section 1031 and thus the name “1031 Exchange.”

To qualify as an investment property, your cabin must have been used for investment purposes and you could have personally used it only for a limited amount of time.

If you can establish that the cabin was used primarily for investment purposes, and then wanted to sell it using a 1031 Exchange to defer payment of tax on any of the profits, you had to designate a replacement property within 45 days of closing on the sale of the cabin. You also would need to have closed on the purchase of the lake house no later than 180 days following the closing on the sale of the cabin. The 45-day rule is a firm deadline.

When you undertake a 1031 Exchange you generally need a third party to act as an intermediary in the transaction and as the trustee for the money received from the sale of the cabin. This intermediary is sometimes called the “qualified intermediary.The intermediary holds the money and could even be viewed as the seller of your cabin and the buyer of the lake home. While you end up with title of the new lake home, you probably won end up with any cash from the sale of the cabin, since the property you purchase has to be at least as expensive as the property you are selling.

If you’ve followed all the rules, you have been able to defer your capital gains tax owed on the cabin until you sell the lake house. Since the lake house purchase is supposed to be an investment as well (the 1031 allows you to exchange investment property for investment property only), you need to think about holding it as investment property for the next two years before you convert it to personal use.

While some attorneys may tell you that is a relatively conservative approach, if you were to convert the lake home to personal use within the two year period, the IRS might disallow the 1031 Exchange and require you to pay tax on the sale of the cabin in the year in which you sold it.

Once the two years has passed, with at least some rental activity, you could move into the home and occupy it for your own use.

If you sell the lake home within the first two years of ownership, you would have to pay capital gains on any profits you made on the home along with paying taxes on any depreciation you might have taken on both the cabin and on the lake house.

However, once you occupy the home as your primary residence, and if you live in it for at least two years, you would then qualify for the $250,000 exclusion ($500,000 exclusion if you are married) from capital gains tax.

This exclusion allows you to not pay taxes on the first $250,000 of profits from the sale of the lake home, taking into account the profits you would have paid on the cabin and other tax benefits that you need to pay back to the IRS. But to get this exclusion, you must use the property as your primary residence for at least two out of the prior five years.

In your case, you would be able to sell the home approximately four years after you purchased it and exclude a significant amount of tax owed from your original cabin.

For more information, you should consult a qualified intermediary who has plenty of experience helping people with 1031 Exchanges, as well as your tax advisor.

December 24, 2004